Valuation of the Week
#11: Playing Tax Games - Valuing an Inversion (Pfizer)

Pfizer is planning an acquisition of Allergan. While there is the usual talk of synergy and control, this deal seems focused on two motivations: the first is that this is a bid by Pfizer to buy Allergan's higher growth and the second is that this is a deal designed to save taxes. Each is worthy of a deeper look, but in this one, I want to focus on just the second motive and answer two questions: What is the tax rationale for this merger? And how does it show up in value?

The US Tax Code

I have vented extensively about the absurdity of US tax law and how it encourages perverse behavior in businesses and individuals. Rather than repeate myself, let me focus on the three aspects of the law that create the most damage:

The level of rates: There was a time four decades ago when the US federal corporate tax rate, at 40%, was in the middle of the global tax rate distribution, with many countries adopting a policy of punitive corporate taxation. The corporate tax rate in the US was last lowered in 1986 to 34% (and then raised back again to 35% in 1993) and has remained unchanged since; with state and local taxes it amounts to close to 40% in 2015. The rest of the world has moved away from the US and lowered corporate tax rates, leaving it with one of the highest marginal tax rates in the world in 2015. (See this KPMG site for tax rates around the world)

Global versus Territorial taxation: Adding to its woes is the requirement that US companies pay the US tax rate not just on US income but on income generated elsewhere in the world. In 2015, it remains one of six countries that follow this practice, whereas the rest of the world has moved to a territorial tax model, where companies get taxed based on where they generate income (and are done). This notion which was born in an age when the US economy was the driver of the global economy and US companies were domestically focused, results in global companies that are incorporated in the US facing much higher tax rates on world income than companies incorporated elsewhere.

The Repatriation Trigger: To cap off this trifecta, US tax law adds a clause that specifies that the “additional US tax” due on foreign income has to be paid only when that income is repatriated to the United States. To the Congressional committee that put this clause in, the words “dumb and dumber” come to mind, because US companies have had the logical reaction and not repatriated foreign income, leaving that income “trapped” in foreign locales. In 2015, it was estimated that the trapped cash amounted to more than $2 trillion, money that cannot be used to pay dividends, buy back stock or make investments in the US, but can be used to make investments anywhere else in the world.

Pfizer's Exposure

To understand how exposed Pfizer is to the vagaries of US tax law, I started by looking at the geographical distribution of Pfizer revenues in 2015:

Region

Revenues (in millions)

% of Revenues

Weighted Marginal Tax Rate

US

$14,993.00

43.08%

40.00%

Developed Europe

$7,006.00

20.13%

21.00%

Developed Rest of the World

$4,562.00

13.11%

27.00%

Emerging Markets

$8,243.00

23.68%

24.00%

Pfizer

$34,804.00

100.00%

30.68%

Note that Pfizer generated only 43.08% of its revenues in the first nine months of 2015. If Pfizer were to be taxed, at the marginal rate in each region, based on where it generated its revenues (regional tax), its tax rate in those nine months would have been 30.68%. As a US company, though, Pfizer would have to pay almost 40% of this income as taxes, translating into significantly higher taxes each period.

Pfizer, of course, took the course of not making this payment, as manifested in two numbers. The effective tax rate that Pfizer has paid over the last five years has averaged to 23.45%, well below 40%, and a significant portion (my rough estimate is $12 billion) of Pfizer’s cash balance of $20.66 billion is trapped, since bringing it back will result in a tax bill of $1.99 billion (using a differential tax rate of 16.55%, the difference between the US marginal tax rate of 40% and the effective tax rate of 23.45%).

Valuing Pfizer under Different Tax Choices

To illustrate the impact that changing the tax code that governs Pfizer has on its value, I considered three scenarios.

Patriot Games: In this scenario, I assume that Pfizer does its patriotic duty (as some critics would label it) and not only decide to bring all of its trapped cash home today (and pay the differential taxes) but repatriate all of its foreign income every year back to the US and pay a 40% marginal tax rate on that income.

Wait-it-out: In this scenario, Pfizer will leave its trapped cash overseas, continue to pay taxes to foreign governments on foreign income but not repatriate the cash. That will leave their effective tax rate well below the US marginal tax rate and Pfizer will have to hope that US tax law gets fixed or that Congress does another one of its “once in a lifetime” tax holidays.

Go Irish: In this scenario, Pfizer buys Allergan and meets the requirements for shifting its incorporation to Ireland. Note that doing so does not affect their taxes on US income but it will not only un-trap their cash but also remove the constraint they face today on foreign income.

The different assumptions that I make about taxes in the three scenarios are summarized below:

Marginal tax rate for cost of debt

Effective tax rate next 10 years

Effective tax rate after year 10

Trapped Cash

Patriot Games

40%

40%

40%

Return immediately, pay differential taxes

Wait-it-out

40%

Pay
23.45% for next 10 years

Pay deferred taxes in year 10

40%

Return in 10 years, pay differential taxes

Go Irish

40%

23.45%

30.68%

Nothing to return, no differential taxes

In the table below, I value Pfizer under each scenario, first using the conventional accounting numbers (which treat R&D as an operating expenses) and next using adjusted numbers (where I capitalize R&D):